Issue 46 - October 07, 2008

History

The financial landscape has been forever changed in what amounts to a historical blink of an eye. Within one month, we saw government intervention in three major publicly held institutions (Freddie Mac, Fannie Mae, and AIG), the largest bank failure in US History (Washington Mutual), the failure of one of the oldest US Investment Banks (Lehman Brothers) and the transformation of the two remaining New York based global investment banks into commercial banks (Morgan Stanley and Goldman Sachs). These steps set the stage for what many hope will be the final step in this catharsis: the implementation of the $700 billion bill that will permit the Treasury to become the de facto buyer and clearing house of the mortgage backed securities which have clogged the balance sheets of banks large and small and as a result brought lending flows down to a trickle.

Equity markets around the world have been hit by a combination of year-end hedge fund and fund of fund redemptions, along with the selling that typically accompanies difficult market episodes. But is has been the bond market that has forced the hand of the Federal Reserve and Treasury as liquidity and credit concerns asserted themselves. For the first time, US Treasury bills effectively were bid up to a point where they yielded nothing and high quality companies and municipalities were forced to pay well above market in order to roll over their short-term liabilities if they could find credit at all.

Changing Hands

Back in March it was hoped that the government’s intervention in the failure of Bear Stearns and concurrent discount window liquidity facilities for broker dealers would provide the needed time and resources for the remaining firms to essentially clear their overleveraged balance sheets by finding buyers for their inventory. However, two factors emerged and progress was negligible. First, the mortgage market had no natural clearing exchange as it had always been essentially an over the counter market and the lack of consistency among the mortgages made determining even discounted prices contentious. Secondly, the few global buyers that were brave enough to try to purchase large blocks of bonds essentially on faith, naturally demanded lower prices than those who held and presumably knew their particulars were willing to accept. This was evidenced in the failure of Lehman. Management always felt that Lehman’s inventory was worth more than the market was willing to pay right down to the moment when they filed for bankruptcy protection. The process of putting weaker institutions into stronger hands was finally going to get underway.

Dominos

At the point at which Lehman failed, the credit dominos were set into motion. Banks began to curtail any extension of credit as they needed every ounce of their remaining capital to meet defaults associated with Lehman. In the absence of bank lines, businesses and municipalities began to draw down on their cash reserves and by definition they began to withdraw funds from money market funds. As these funds had fewer dollars to invest, they did not need to purchase as much commercial paper (short dated corporate bonds) or short-term municipal notes. In order to attract the remaining liquidity to their names, issuers have been required to pay extraordinary rates. Unfortunately this type of cycle feeds upon itself until there is simply not enough credit to go around. The bank lines are gone, the cash reserves are drawn down, and the short-term borrowing facilities have evaporated. There had to be a mechanism to break this destructive cycle and that is what the $700 billion bill will attempt to do.

The Road Back

In the coming weeks, the credit markets will continue to experience stress and the details of the mortgage auction process will have to be fleshed out. On the equity side, there will continue to be fire sales. But much has been accomplished in this most historic month. The weakest financial players have been stabilized, sold or liquidated. Deposit insurance has been enhanced and we should begin to see the rotation away from US Treasuries and back into other traditional short-term alternatives. We should also see relief in the pivotal interbank lending market (Libor) as risk premiums abate.

The economy has undoubtedly sustained a significant blow, both in the US and on a global scale. Unemployment has accelerated and earnings will be impaired for a period of time. Equity markets have disconnected to a degree from current events as margin calls and redemptions have mandated selling which was not based on fundamentals. But we are at a point where investors will begin to sharpen their pencils. As Warren Buffett has said on numerous occasions, it is in down markets that he has made most of his best returns. His recent shopping spree has been breathtaking with multi billion dollar investments in General Electric and Goldman Sachs. As the markets digest these recent events, it will be the assessment of earnings in this new environment versus current valuations that will be the driver of bond and equity returns. Investors have rarely enjoyed a perfect economic backdrop in which to invest and this time we are far from perfect. But the dislocations have been tremendous particularly in some of the highest quality investments as they have been the most reliable source of funds. The next few months will not necessarily be easy for the markets as hedge fund redemptions in particular continue to play out, but as we have noted on many occasions, uncertainty is a strong headwind for markets. With all that has transpired and as painful as this may have been, there is now much more reason for large pools of money to come into the markets. The weak players are now in the hands of strong owners and credit markets should begin to once again function properly.

• History
• Changing Hands
• Dominos
• The Road Back